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Big Questions Need Answering After Stress Tests

Friday, 23 Jul 2010 | 11:28 AM ET

A number of analysts still believe the big stress-test questions need to be answered despite the European Union attempting to draw a line in the sand.

“Even if concerns over counterparty risk were to subside in response to the test results, market participants would be unwise to assume the tests had demonstrated that the banking system was soundly-based and free from threats to its stability," Stephen Lewis, chief economist at Monument Securities, said.

"No stress tests could, in principle, achieve that result," Lewis said. "Such tests only take account of what the erstwhile US Defense Secretary, Mr. Rumsfeld, used to call the 'known unknowns.' What usually causes damage, however, are the 'unknown unknowns,'" Lewis said.

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Authorities would not have included subprime mortgages in a 2007 stress test as they simply would not have assumed there was trouble brewing in this huge market, Lew said. Nor does he believe it is possible to prepare for doomsday.

"To be 100 percent confident that banks are holding enough capital, it would be necessary for a stress test to assume financial Armageddon," he said. "Such a test might well indicate that banks should hold capital, and very little else, on their balance sheets. If banks were then to act on such results, they would no longer able to carry out their economic function."

Julian Pendock, a partner at Partner Senhouse Capital, told CNBC that the big questions will not be answered until the we see what happens to long term borrowing costs.

The European Debt Crisis - See Complete Coverage
The European Debt Crisis - See Complete Coverage

"People are forgetting that debt will mount even as budgets are cut, so, in fact, when the markets reopen, in absence of another bailout, then they may well have to take a huge haircut as the cost of borrowing goes through the roof," Pendock said.

"Thus banks could actually be said credibly to pass the stress test, but only for the duration of ECB/IMF support, i.e. Greek banks could credibly be argued to be solvent at this juncture or over the next 12 months, but thereafter, fundamentally bust," Pendock said.

"The stress tests focus on balance sheet strength, but one must remember that the cost of funding is heavily subsidized by the 'cash for trash' scheme," he said.

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